Thursday, June 26, 2014

"it is hard to find any deep rationale for a four per cent target. At least the existing two per cent inflation target stands for something, because central bankers can portray it as the moral
equivalent of zero. "

The 4% non-solution

Kenneth Rogoff

Business Standard Opinion

For some time now, there has been concern that central bankers have "run out of bullets". Having lowered their policy rates to near zero, they have engaged in increasingly extravagant measures such as "quantitative easing" and "forward guidance".
Given the fog cast over real economic activity by the financial crisis,
it is difficult to offer a definitive assessment of just how well or
badly those measures have worked. But it is clear that there must be a
better way to do things.

There is no longer any reason to let the zero bound
on nominal interest rates continue to hamper monetary policy. A simple
and elegant solution is to phase in a switchover to a fully electronic
currency, where paying interest, positive or negative, requires only the
push of a button. And with paper money - particularly
large-denomination notes - arguably doing more harm than good, currency
modernisation is long overdue. Using an electronic currency, central banks could continue to stabilise inflation exactly as they do now. (Citigroup's chief economist, Willem Buiter, has suggested numerous ways to address the constraint of paper currency, but eliminating it is the easiest.)

A second, less elegant idea is to have central banks simply raise their
target inflation rates from today's norm of two per cent to a higher
but still moderate level of four per cent. The idea of permanently
raising inflation targets to four per cent was first proposed in an
interesting and insightful paper led by the International Monetary
Fund's chief economist, Olivier Blanchard, and has been endorsed by a number of other academics, including, most recently, Paul Krugman. Unfortunately, the problem of making a smooth and convincing transition to the new target is perhaps insurmountable.

When Mr Blanchard first proposed his idea, I was intrigued but
sceptical. Mind you, two years previously, at the outset of the
financial crisis, I suggested raising inflation to four per cent or more
for a period of a few years to deflate the debt overhang and accelerate
wage adjustment. But there is a world of difference between temporarily
raising inflation to address a crisis and unhinging long-term
expectations.

After two decades of telling the public that two
per cent inflation is nirvana, central bankers would baffle people were
they to announce that they had changed their minds - and not in some
minor way, but completely. Just recall the market's "taper tantrums" in
May 2013, when then-Fed Chairman Ben Bernanke
suggested a far more modest turn in monetary policy. People might well
ask why, if central bankers can change their long-term target from two
to four per cent, they could not later decide that it should be five or
six per cent?

Given the likelihood of a confused, mistrustful
public, it is hard to find any deep rationale for a four per cent
target. At least the existing two per cent inflation target stands for
something, because central bankers can portray it as the moral
equivalent of zero. (Most experts believe that a true welfare-based
price index would show significantly lower inflation than government
inflation statistics indicate, because official data fail to capture the
benefits of the constant flow of new goods into the economy.)

There is an analogy to the problems countries faced when they tried to re-establish the gold standard after World War I. Until the war, money was backed by gold and could be redeemed at a fixed rate. Though the system was highly vulnerable to bank runs and there was little scope for a monetary stabilisation policy, people's confidence in the system enabled it to anchor expectations.

Unfortunately, the system completely collapsed after the war broke out
in August 1914. Revenue-desperate combatants were forced to turn to
inflation finance. They could not simultaneously debase the currency and
back it with gold at a fixed rate.

After the war, as things
settled down, governments tried to return to gold, partly as a symbol of
a return to normalcy. But the revived inter-war gold standard
ultimately fell apart, in no small part because it was impossible to
rebuild public trust. A move by central banks to a long-term four per
cent inflation target risks triggering the same dynamic.

Fortunately, there is a much better way. Moving to an electronic
government currency would not require a destabilising change in the
inflation target. Minor technical issues could easily be ironed out. For
example, ordinary citizens could be allowed zero-interest-transactions
balances (up to a limit). Presumably, nominal interest rates would move
into negative territory only in response to a deep deflationary crisis.

But when such a crisis does occur, central banks could power out of it
far more quickly than is possible today. And, as I have argued
elsewhere, governments have long been penny-wise and pound-foolish to
provide large-denomination notes, given that a large share is used in
the underground economy and to finance illegal activities. Moving to a
21st-century currency system would make it far simpler to move to a
21st-century central banking regime as well.